£37bn won't fix this fiasco

The injection of £37bn of taxpayers' money into the capital base of three British banks is the gravest event in the modern financial history of the UK. Without it, the financial system would have disintegrated and the economy imploded into depression. This brute reality is tribute not just to the powerful global forces destabilising western banking systems but also to breathtaking business misjudgment, epic regulatory failure and a 20-year indulgence of now-defunct "free market" principles.

The scale of the response was required by the scale of the debacle. The banks had accumulated trillions of pounds of assets essentially built on "securitisation" - bundling up streams of income, insuring them, and selling them as securities to investors - whose value had been imperilled not only by the crisis in property markets but by recession generally. The buyers and insurers of these instruments have fled the markets. The banks are left with depreciating assets that have to be funded as they mature, and have no way of creating new ones. Paralysis has settled on the entire financial system.

As a result the banks needed £37bn of capital just to support the level of advances they had made, absorb write-offs and begin to make new loans. They also need the £250bn loan guarantees and £200bn of liquidity from the Bank of England. It is incredible that they could have arrived at this position while distributing huge dividends to their shareholders and vast bonuses to staff in their investment and security trading arms. They were running unsustainable businesses. Small wonder that one source close to the talks over the weekend told me the men running the most unsustainable bank, RBS, were " broken".

Which is why there can only be a qualified sigh of relief at what has happened. It is good that they have much more solid balance sheets; good that Germany and the US seem set to follow. The market response in Europe and the US yesterday was heartening. But this is only the end of the beginning.

The banks' business model has to be reconceived. It is all very well the government demanding and the banks accepting as part of the deal that they will return to the lending levels of 2007. But how? Lending in 2007 reached a climax as savings from Asia and the oil-producing states were recycled to Britain via New York. We sold the Asians those "securitised" income streams, insured via credit derivatives, with management teams incentivised by what everyone now agrees were recklessly high bonuses. The proceeds buoyed up the property market with familiar results. All is history.

Chief secretary to the Treasury Yvette Cooper says the government is not in the business of running banks. But it is. The banks raise savings and lend alike in conditions determined by government. It will now have to decide on how to re-open and regulate the securitisation and credit-default swaps markets as part of the larger reform of the international financial system that Gordon Brown promises. It will also have to stimulate demand for the offers of loans it wants the banks to make. And it could, if it chose, deploy its ownership of the banks to insist they build a new business model on supporting innovation and long-term investment. This will require able men and women - the best. And they will expect good rewards.

It is a critical time. Depression may have been avoided, but how the financial system is managed now will determine how severe the recession is and the future character of British capitalism. The government is now necessarily in the banking business, and must confront its new responsibilities.